Dave Merrill Contributes Article on ESG in Advisor Perspectives
Environmental, social and governance (ESG) investing is a major force with more than $20 trillion in assets. But, for it to succeed, investors need to know that companies are reliably achieving their ESG promises. This need has driven the growth of single-company ESG scores generated directly by ratings providers from the dozens of ratings they provide covering more granular issues. The single rating delivers a comparable rating across multiple ratings agencies, which, due to divergent approaches on underlying ratings, cannot otherwise be easily supported.
[This article appeared in Advisor Perspectives]
The days of solely implementing negative screening, excluding “sin stocks” or oil and gas companies, are long past. ESG integration is now a major focus of Wall Street and along with recognition of real progress achieved comes some warranted skepticism. The Remarkable Rise of ESG, a short piece that appeared in Forbes, did an excellent job of walking through the early days of ESG/SRI and how far we have come. More recently, How Socially Responsible Investing Lost Its Soul, by Rachel Evans of Bloomberg BusinessWeek, suggested a wake-up call, warning that Wall Street is predictably churning out ESG products that will disappoint naïve but well-intentioned investors. Taking just one aspect of where we are today, the single-company ESG rating, this can be used to check our current position on the evolution of ESG investing and help us to project where we are likely headed from here.
Clearly integrating a single ESG company rating into investment processes is quicker and less taxing than deciding how to incorporate over 30 individual ratings per company. The single rating is a summary of underlying ratings or scores on that company from a ratings vendor covering ESG issues. Without judging if a single rating is a perfect metric, we can agree that it is easy to understand, compare one company to another and to support decisions. ESG analysis has evolved to the stage where the single-company rating is widely produced and leveraged.
As an active participant in risk and quantitative investment analytics, the evolution of ESG factors, research and investing has been a captivating journey. With the single-company rating, it is hard not to reflect back on the positioning of value at risk (VaR) as the best single measure of risk (at least before 2008). While practitioners knew a single risk measure was not a full answer to any question, there was not a lot of effort made to broadly educate and communicate the known limitations. Vendors pushed their systems’ abilities to calculate VaR, increasing emphasis on a single number as a panacea for a very complex reality. To be fair, ESG ratings don’t forecast potential losses, but there are some parallels in their rise to prominence.
A lot has been written on the inconsistency of vendor-supplied ESG ratings. CRSHub did a study in 2018 and found the correlation (r-squared) of company-level ESG ratings using two leading vendors was only 0.32 (pretty low versus 0.90 in its sample for credit ratings). Those statistics will not surprise practitioners.
Let’s start with positives and negatives about leveraging a single ESG rating.
The good – A single score drives more widespread access to ESG analysis, facilitates investment decisions and grows revenue for asset managers. The two largest ESG ratings agencies, MSCI ESG and Sustainalytics, have grown their usage based on single scores. The focus on single-company ratings comes down to revenue and the fact that it is the practical first choice for over 80% of asset managers and investors, for the following reasons:
- More investment decisions can be powered by ESG ratings. It supports marketing that is successful with broad audiences.
- A top-level score is a great first step in a screening process or monitoring companies. This provides an improved and more sophisticated approach than negative screening by industry (e.g., oil and gas or tobacco).
- People want easy answers, not lots of data and questions. Looking at individual ratings within, say, the governance category leads to confusion. Even if a company-level ESG rating is inconsistent with another credible source, or important underlying factors show high risk, the need for an answer wins.
- Single-company ratings allow for balance between when companies are doing well and when headlines highlight undue risk.
- It mutes out known, unresolved biases. There are well-documented issues that show problems with ratings related to size, geography and industry. Several studies have pointed at these findings including Ratings that Don’t Rate, by the American Council for Capital Formation. MSCI ESG literature claims size (financial capacity) allows for more resources to be focused on ESG issues, which would artificially support higher ESG scores.
The downside –Too much focus on a single rating leads companies to manage to that number. A single rating can hide important information:
- External pressure on companies to address specific shortcomings could be reduced. If a company is rated low in specific areas – except in the most extreme cases – it could say, “But overall we are doing well. We have to look at the full picture.”
- Internal resource and financial commitments to address specific shortcomings could be reduced if just the overall rating gets attention. The details become less important as companies manage to the topline number.
- If all incentives are connected to a rating, then all actions will be as well. These incentives include membership in a broadly traded index, and how a company is compared to its peers.
- There could be consolidation among firms doing ESG research. Specialized ratings firms that only focus on specific issues such as for carbon impacts (within E) would need to partner or be acquired to be a part of producing a single rating. With the importance and value of their research reduced, the overall quality and depth of ESG research may diminish.
- It reduces pressure on firms to increase the quality of their ratings. A single score can be backward looking and lack predictive power when it comes to meeting ESG goals.
- There has been criticism in the credit world due to conflicts of interest between issuers and rating agencies, as is the case with credit ratings. A single rating could increase those conflicts.
- Breadth could be prioritized over depth of coverage, presenting a disincentive to increase the quality of research and instead focus on covering more names.
- Overly subjective methodologies could more slowly evolve into more objective and transparent approaches. With less scrutiny on the underlying methodology, the improvement of individual underlying scores will be slower.
The single rating will persist. It’s easy, handy and approachable. It is a vast improvement over negative screening. It favors investors and information consumers who are interested in but do not want to have to get into details. Maybe we will see more conversation about the use of single scores for the E, the S, and the G. Some will argue that the governance rating should always be on its own and that social and environmental have more standing as a combination.
Increasing flows to ESG products will allow for more options and choices, both around what analysis and ratings are produced, and what investment opportunities are made available. The analytics and investment opportunities don’t have to be totally in sync, but it is best when the mutual support is there and when the two are separated without conflicts. The rise of the single rating strategically favors the largest ratings firms, with asset managers creating and marketing new products preferring a simple and streamlined approach.
The fact that we are seeing criticism (see the BusinessWeek article noted above) is a plus. We can demand and expect continued evolution in how ESG ratings are produced and leveraged. The current scale and expected growth of ESG factors and ratings in investment decision making will downplay the shortcomings of the single ESG rating. ESG products will doubtless be replaced by more sophisticated offerings that are backed by higher quality data and longer histories as the ratings evolution continues.
Dave Merrill is a partner with TechCXO in Boston.